Stephen Powell and Kathrine Meloni of Slaughter and May explore how an investment-grade borrower might view some of the provisions that are being raised by lenders in current lending discussions.
"The years since Lehman have, if nothing else, taught us to expect the unexpected, but investment-grade loan terms should take into account the relationship nature of the transaction and not be engineered beyond what is necessary."
Loan documentation has become longer in recent years, in part due to the additional risk factors highlighted by the financial crisis, which lenders have subsequently sought to allocate contractually. How might an investment grade borrower view some of the provisions that are being raised by lenders in current lending discussions?
The new risk factors
The storm in the eurozone appears to have settled (for the time being at least) and the attention of a restructured and generally healthier banking sector, fortified by ECB and central bank liquidity, is currently focused on the ancillary business of larger corporates. This is good news for borrowers who are in a position to leverage their bank relationships to minimise interest and fees.
Investment grade borrowers may not, however, have noted a corresponding improvement in documentation terms, which have become more complex in many cases. The LMA’s recommended forms of facility agreement for investment grade borrowers (the LMA Agreements), have increased in length by around 30 pages since 2006. Negotiated loan agreements are likely to be even longer as there are a number of additional provisions that are debated on almost every transaction, to deal with issues on which there is not yet sufficient certainty or market consensus to import a single position into the LMA templates.
Most of the changes affect the more mechanical areas of the agreement, many of which would once have been put into the category of “boilerplate” and rarely disturbed in negotiations. This is largely the result of the events of the past half-decade having revealed or thrown up new risks or costs which pre-existing documentation was not designed to address.
These include the risk of lender default, the possibility of a euro break-up, perceived weaknesses in amendment and waiver provisions and the contractual protection afforded to agent banks (both of which came to the fore as a result of the restructuring transactions that occurred during the most challenging period of the downturn) as well as the costs associated with the raft of regulatory measures developed in response to the financial crisis, most importantly, the implementation of, and compliance with, Basel III.
The manner in which these issues are affecting investment grade loan agreements is outlined below.
Lender default and euro break-up
The risk of lender, as opposed to borrower, default is a new risk factor that the loan market swiftly moved to address. In 2009 the LMA published a set of optional clauses for dealing with finance party default and market disruption. These are commonly referred to as the Lehman provisions, and are primarily intended to facilitate the management of defaulting or insolvent lenders and agents. Some of the optional provisions originally put forward by the LMA as part of the Lehman provisions and which became widely adopted – for example, the “cashless rollover” provisions providing for cashless repayment and drawing on the rollover of a revolving facility loan – have now been incorporated directly into the LMA Agreements themselves.
The impact of the fragmentation of the euro on euro-denominated loans was the subject of extensive debate during late 2011 and 2012. Alterations were subsequently made to loan documentation (including the LMA Agreements) with a view to minimising any risk of re-denomination should one or more countries exit the euro. These were in general, technical and very minor, most English law-governed corporate loan documentation being considered at the safer end of the risk spectrum for that purpose.
Defaulting lenders and the provisions aimed at euro fragmentation are examples of provisions designed to address risks which have the potential to affect (or should affect) lending documentation of all types; the risk of lender default or of re-denomination of a euro loan agreement should not differ according to the quality of the credit or the type of facility. Further they are points on which the interests of borrowers and lenders may in most cases be aligned, which accords them easier boilerplate status. These provisions have been, in the main, accepted into investment grade lending and are not generally controversial.
Amendments and waivers and the position of the agent banks
The suggestion that amendment and waiver provisions and the protections afforded to agent banks should be tightened up has gained some traction in the leveraged sector of the market, as it is in the leveraged loan market that these risk factors are of most relevance.
As the 2007–2009 crisis spread from the banking sector to the broader economy, many leveraged borrowers found themselves in difficulties or unable to refinance and that market was dominated by restructurings and “amend and extend” transactions. The ability to restructure a broadly held leveraged loan without unanimous lender consent can be valuable. The number of restructurings led to increased focus on the scope of the LMA amendments and waivers clause and on what some lenders might perceive as weaknesses in those provisions. The restructuring round also led to a significant amount of work for agent banks, in some cases involving difficult questions of contractual interpretation of not only the credit agreement, but also the intercreditor and security arrangements, causing them to focus on their own exposure under existing contractual provisions.
As a result, in September 2012 the LMA extended the list of matters reserved to unanimous lender consent in its leveraged facilities agreement and made a number of amendments to the agency provisions, including a broadening of the indemnity protection offered to the agent by the borrower and the addition of more comprehensive limitations on the agent’s liability for its actions.
These issues are not, however, currently fully addressed in the LMA Agreements, reflecting that in the investment grade market, there is still no market consensus on the appropriate manner to address those risks, and even in some instances, whether they should be addressed at all.
The extent to which such provisions are appropriate in investment grade agreements is debatable.
Lenders may argue that consistency across the loan market is an aid to efficiency and point out that a lot can happen during the term of an investment grade loan. The last five years provide plenty of illustrations of how swiftly investment grade credits can move into the sub-investment grade space changing the profile of their financing options considerably. They may also point out that even if the provisions are likely to be of neutral impact in practice, there would seem little impetus for the borrower to negotiate them, and they should instead be treated as boilerplate.
The inclusion of provisions that are unlikely to be invoked may appear harmless, but many investment grade borrowers make (and sustain) the argument that such provisions are unnecessary and irrelevant.
The bread and butter of the investment grade loan market is the revolving credit facility, which is often put in place for standby purposes and thus remains undrawn. Such loans are not generally amended, they do not contain significant restrictions on the business that require waivers, they are unsecured and they are not generally traded. Investment grade revolvers should therefore be a relatively simple proposition for an agent bank when compared to a secured, tranched and leveraged facility, which is also likely to be offered to a much broader and more liquid syndicate.
The wholesale adoption of the more sophisticated plumbing used in the leveraged loan market into investment grade facility agreements can make documentation discussions less efficient due to their requiring more extensive negotiation. For example, it is partly because leveraged loan agreements (including the LMA’s template) contain a more extensive list of decisions requiring all-lender consent, that additional provisions intended to mitigate the consequences of that broad list, such as “you-snooze-you-lose” and structural adjustment clauses have been adopted in that market.
There are valid arguments on both sides. In some cases, the lenders’ approach might indeed be the right approach – but at the time of writing, these issues are being considered on a loan-by-loan basis and are not by any means raised on every deal.
Basel III and increased costs claims
In recent years banks have been deluged with new and more onerous regulatory requirements, most with the potential to impact corporate loan products, directly or indirectly. In part due to the unpopularity of certain measures among affected parties, the process of regulatory change has been a protracted one, especially the finalisation and implementation of the various elements of Basel III.
Under the increased costs clause, a feature of nearly all loan agreements, lenders can claim from the borrower any increased costs that, in summary, result from a change in law or regulation after the date of the agreement and are attributable to that lender’s participation in the relevant facility.
Whether costs relating to Basel III should be recoverable under the increased costs clause has been debated since Basel III was first announced and remains contentious. The text of the LMA clause (which refers to Basel III only in a footnote, reminding the parties that they may wish to address it specifically) is negotiated on almost every transaction. Since the finalisation of the legislation implementing Basel III in the EU (known as CRD IV and due to come into force on 1 January 2014), it has become common for lenders to propose that the clause be altered to make clear that related costs, notwithstanding that they may no longer constitute a change in law, will nonetheless be recoverable under the clause, at least until such time as CRD IV has been fleshed out and is fully in force.
Views on whether this is appropriate for investment grade borrowers differ. Some borrowers may accept that this is the quid pro quo for current pricing levels and place store on the strength of their lending relationships. Others may view an explicit acknowledgement of lenders’ rights to claim additional costs as in direct conflict with the concept of relationship lending. They may also point out that in terms of capital allocation, investment grade corporate borrowers remain more efficient than other types of lending, even once Basel III is implemented.
Again, however, if the borrower is subjected to more onerous contractual terms, exceptions and mitigation provisions are likely to be negotiated. If the Basel III carve-in is accepted, and the risk is placed on the borrower, lenders are quite often willing to accept some sort of sensible limitation on the scope of the increased costs indemnity in investment grade agreements in particular. For example, we have seen a significant number of borrowers argue successfully that if lenders are to be entitled to claim under the increased costs indemnity for Basel III costs, they should only be permitted to do so within a specified period (often six months) following the relevant change in law.
The issues outlined above are some of the key drivers of changes to investment grade lending terms in recent years, but there are of course many others. Space does not permit analysis of some other issues of key importance to investment grade borrowers.
For example, the Basel III liquidity coverage ratio (LCR) requires banks to hold liquid assets in an amount equivalent to their committed outflows during a 30-day stressed scenario based on an assumed drawdown rate. This is a significant issue for investment grade borrowers as they are more likely to have liquidity facilities in place (for example, to backstop a commercial paper programme) and the requirements of the LCR are more onerous for facilities that are considered more likely to be drawn down in a stressed market – namely, liquidity facilities including swinglines. Whether borrowers are permitted to collateralise derivatives exposures under current lending terms is another topic being considered by many borrowers in light of the European Market Infrastructure Regulation and other regulatory developments affecting the derivatives industry.
On top of crisis-driven regulatory changes, participants in the loan market have had to grapple with reforms to LIBOR and other benchmarks and the impact of the Foreign Account Tax Compliance Act (FATCA). FATCA requires foreign financial institutions to provide detailed information to the IRS regarding their US account holders or face a punitive withholding tax on, inter alia, their US-source income. The emergence of inter-governmental agreements (IGAs) should mean that the impact of FATCA is not as significant as initially feared (and, importantly, enable lenders in IGA jurisdictions to accept the tax risk) but FATCA requires some discussion in most current transactions.
These are all topics on which there is no defined market consensus, and in respect of which the LMA Agreements (rightly in our view) do not yet present a starting point for negotiations.
Conclusion: good news and less good news but not bad news
It is acknowledged that addressing some of the risk factors currently affecting the loan market generally in investment grade documentation is advisable for the sake of clarity. As market consensus settles on some of these points, it seems likely that further provisions will be added to the LMA Agreements.
Whether some of the provisions being discussed in current transactions are warranted in the investment grade market, however, is questionable. The years since Lehman have, if nothing else, taught us to expect the unexpected, but investment grade loan terms should take into account the relationship nature of the transaction and not be engineered beyond what is necessary. In circumstances where borrowers find it difficult to understand the justification for, or relevance of, the proposed provisions, a range of approaches is likely to develop. Negotiation will be required, which may have implications in terms of the time and costs involved in settling the agreement. After all, the most important characteristic of the loan product is its flexibility and adaptability to the circumstances of the credit, in terms of documentation as well as pricing.
On the other hand, the arguments for and against addressing particular issues can be finely balanced. The fact remains that for most borrowers, achieving the best pricing, the right maturity profile and a limited and flexible set of covenant terms are more significant determinants of the success of a refinancing than the length of the boilerplate.